What is missing in the stocks with 'multibagger pricing'...

(Jul 31, 2015)

In this issue:
» The proof you need to seek in multibagger stocks
» Man vs Machine conundrum to threaten Make in India?
» Why China's valuations may be misleading
» ....and more!

00:00

A decade is a reasonably long time when it comes to investments. If you were amongst those looking for stocks a decade back, you would know exactly what I mean.

The search for good stocks then was largely restricted to ones that would secure your capital. And in the process offer reasonable returns over a period of time. As an investor in stocks your biggest fear would have been losing money in it. So the hunt for safe stocks was the norm rather than exception. The fear of missing out on 10x returns would have hardly crossed your mind them.

Over the years, investors have got more acquainted with the concept of multibaggers. And hence even the quest for good stocks has seen a dramatic shift.

My first brush with the term 'tenbagger' was in 2003 when I read 'One Up On Wall Street'. But the real meaning of the term dawned upon me, a couple of months later, while assisting a senior for a StockSelect recommendation. The company being researched did not have all the ingredients that would qualify it for a safe and sound investment. Titan, then called Titan Industries was largely a watchmaker foraying into branded jewellery. The company had debt on its books and faced stiff competition from the unorganized players. So to me, prima facie, the stock did not appear to be the safest choice for recommendation.

But as part of our process, we started decoding the return on equity of the company. And it was then that the rationale of my senior's assessment that the stock has the makings of a tenbagger, dawned upon me. The management of Titan was all focused on becoming debt free and building brands. So while we saw interest costs tapering off dramatically in the ensuing years, margins were expected to strengthen. And both put together were expected to put Titan in the league of companies fetching the best shareholder returns. Since then the focus on return ratios has stayed with me as the bedrock in the quest for multibagger stock ideas.

Interestingly, every company posting growth in excess of 20% in quarterly earnings is today branded as multibagger stock. Every small company with high growth potential gets valuation multiples fit for blue chips. And every publication outlining the secrets to finding multibaggers talks about growth and valuations. There seems to be hardly any emphasis on whether the high growth stocks are doing enough to create shareholder wealth. In other words, there is a stark disconnect between the potential of the so-called multibaggers and their return ratios.

There are scores of companies today that are growing very fast while leaving little on the table by way of returns for shareholders. In most cases the return ratios (return on capital employed) is lower than cost of capital. Needless to say, without improvement in the ratio, the companies will destroy more wealth over the next few years as against creating it.

But do investors care?

The aspiration for riding the next multibagger stock is running high. And the biggest fear in the minds of investors is of losing out on any tenbagger. So it is not uncommon to find stocks with return on equity of less than 12% trading with price to earnings multiple in excess of 30x. Such 'multibagger pricing' of the stocks is based on nothing else but growth potential. And whenever the growth takes a backseat, stocks with poor returns will shed their multibagger pricing for good.

So by all means look for multibagger stocks. But do not be in a hurry to pay multibagger valuations for a stock that fails to offer proof of wealth creation. A disconnect between return ratios and valuations can, sooner or later, undo your quest for big returns.

Do you look for high return ratios while searching for multibagger stock ideas? Let us know your comments or share your views in the Equitymaster Club.

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Speaking of high growth businesses, one cannot fail to mention companies capturing the 'Make in India' opportunity. And in a recent issue of The 5 Minute WrapUp, my colleague Ankit had written about the Man vs Machine conundrum that could thwart India's manufacturing goals. It seems China is already taking the challenge head on.

To be in the reckoning with innovative nations, China has been stepping up investments towards upgrading technology in manufacturing. In fact, one such manufacturing firm in China has set up the first unmanned factory in the country. Here, the processes will be operated by computer controlled robots, unmanned transport trucks and automated warehouse equipment. The only human role will be that of the technical staff that will monitor this system through their computers. China's rising wage costs is forcing the manufacturing companies to look for more cost-effective options.. And thus investment in technologies is becoming more crucial. The intent is to push the country towards more sophisticated manufacturing processes as against labour intensive ways.

But when such robot powerhouses become a dominant part of the workforce in populated countries, it is bound to have a social impact. Higher involvement of these robotic machines can lead to wide disconnect between the workforce and jobs.

China is already facing issues in its manufacturing activity. As per an article in Mint, China's manufacturing PMI has been contracting since December 2014. The manufacturing PMI has been below 50 for six months. Sustained job cuts have been one of the prime reasons for this sector contracting.

China's Manufacturing PMI contracts below 50 in last one year

Now such signs could have more serious implications on a populous country like India, where manufacturing has been on the weaker side. If cheaper robot-manufactured Chinese goods continue to find their way into India, the Make in India dreams could see an early debacle.

03:45

While China's manufacturing activity continues to contract, if one looks at the stock market performance, in the last one year, the picture is entirely different. The Shanghai stock market index has gained around 66% in last one year. This is quite encouraging, despite the recent sharp correction. The Chinese equity markets have witnessed sharp correction in June 2015 and have remained quite volatile since then. And as per Buffett's favourite indicator, the market is now beginning to look relatively attractive. As per Fortune, China's market capitalization to GDP ratio indicates that the Chinese stocks are not overvalued. At 110% for China, the ratio looks relatively attractive when compared to 125% for the US. However, looking at the valuations in isolation would be very misleading. Foreign institutional investors looking to invest in China are hardly finding enough comfort in the underlying fundamentals. For Chinese companies both growth and profitability will be hard to come by in the next couple of months. Hence, even though the broader markets may seem attractive, those looking to invest in Chinese stocks will not be spoilt for choice.

04:46

After opening on a strong note, the Indian stock markets have continued to climb up. At the time of writing, the BSE-Sensexwas trading higher by around 379 points. Barring stocks from the power sector, buying activity was witnessed across the sectoral indices. Stocks from the realty and banking sectors were in maximum demand. Both the midcap and smallcap indices were also trading in the green, with the BSE-Midcap and BSE-Smallcap indices up by about 1.2% and 1% respectively.

04:55

Today's investing mantra

"There are normally 10 filters or so that I go through when I hear an idea. The first is can I understand the business and understand the downside not just today but five to ten years from now. There have been very few times that I've lost 1% of my net worth. I might be risk averse but I am not action adverse."- Warren Buffett.

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